'Old economy' stocks look expensive and software screams cheap. Is that enough to end the rotation?

CNBC Finance

9 min read

Monday's batch of Wall Street research made one thing clear: More people are starting to throw in the towel on software. While the sentiment makes sense â analysts aren't blind to the price action and know their posture is out of step ahead of some key earnings reports â one has to wonder whether it could be a sign the rotation away from these stocks and into cyclical, old economy names has run its course. Price target cuts for Workday at Cantor Fitzgerald, Morgan Stanley, and Jefferies. Same thing for Autodesk at UBS, Stifel, and Morgan Stanley. Salesforce price targets slashed at Morgan Stanley and Jefferies. BTIG and Stifel did the same for Snowflake . Even cybersecurity isn't safe, with Stifel cutting their target on CrowdStrike and Wedbush removing Palo Alto Networks from its "best ideas" list. To be clear, most of these firms still view the companies as buys given where the stocks are versus the price targets. However, it's clear Wall Street has finally gotten the message that the premiums once paid for these asset-light businesses will be harder to come by in the era of AI. The new hot acronym on the Street â HALO, coined by CNBC's own Josh Brown â embodies this shift away from a market in which the mostly asset-light FAANG and the "Magnificent Seven" cohorts dominated. It stands for "Heavy Asset, Low Obsolescence." Unlike FAANG or Mag 7, it doesn't refer to a select group of ordained stocks. Rather, it refers to any and all companies that investors deem resilient to AI pressures because they can't be competed against with a simple prompt into a generative AI model. Sure, we may think it's fanciful that an AI model can create the next CrowdStrike. But that is what the market fears at the moment, and this is a tough tape to fight. The logic behind HALO makes sense. After all, you can't AI prompt your way into a Big Mac from McDonald's or a venti coffee from Club name Starbucks . Nor can you prompt your way into manufacturing the natural gas turbines needed to meet AI-driven electricity demand (hello, GE Vernova ). Same goes for the fiber optic cables needed to quickly transmit data in AI data centers (a la Corning ). But there's a potential problem: Without a tangible benefit from AI that drives margin expansion and related earnings growth, there is a limit to how far investors can push these stocks before the HALO theme turns into nothing more than a sentiment-driven momentum trade. If earnings aren't growing but the stock price is going up, you're just paying more for the same dollar of earnings. That means the stock is getting more expensive and, in turn, there's less value to be had. Take a look at this chart examining valuation dynamics across all 11 sectors in the S & P 500, using the State Street ETFs for each. So, what do we see? Energy, industrials, materials, staples, utilities and health care have proven clear beneficiaries of the HALO trade. All six sectors have seen earnings-based valuations increase over the past six months to levels above their five-year average. In particular, the multiple expansion for the industrials sector â home to the likes of GE Aerospace , Caterpillar and Pratt & Whitney owner RTX Corporation â is notable. It is not only trading above its five-year average, but it's also at its highest level in three years. Led by Exxon Mobil and Chevron , the energy sector is also essentially at its highest level in level years. On the flip side, information technology â dominated by Apple , Nvidia and Microsoft â and communication services â where Meta and Google parent Alphabet are the biggest players â have fallen below their respective five-year averages over the past six months. Meanwhile, the consumer discretionary sector â dominated by Amazon and Tesla â has also traded lower, but it's help up better versus its five-year average. And that makes sense, considering it is the most HALO-like of the group. Amazon may get lumped into the tech trade, but it owns a ton of warehouses, data centers and even grocery stores â very much real assets. Same goes for the financials, where investors are also wondering how much of the operation can be disrupted by AI. What does this all mean? The high-level takeaway is that this rotation may be starting to run its course. The valuations of prior secular growth market darlings have compressed, and the newly anointed cyclicals have become stretched â exactly the reason Jefferies analysts downgraded Deere on Monday after the stock's more than 40% year-to-date rally. However, the caveat is that while these valuations are based on FactSet estimates, the issue plaguing the market is one of fear and mistrust. Specifically, investors are afraid that the earnings estimates are too high for companies that could be disrupted by AI. In other cases, perhaps the estimates are too low for companies that could take advantage of AI to unlock efficiencies and boost profits. The uncertainty around the future creates a mistrust of the earnings multiples. That means tech stocks look cheap based on current estimates â and the HALO trade is selling at a premium to historic valuations â but investors are not so sure. If you don't trust the financial metric the valuation is based on, you inherently can't trust the valuation âgarbage in, garbage out. Let us be clear: We aren't saying the estimates are definitely garbage. We simply acknowledge that fear has gripped the market. Our pushback is that whenever fear is controlling the price action, it generally means the market is overshooting the fundamentals to the upside and the downside. That tends to be the case even when the fear â artificial intelligence disruption â is legitimate. Here is where we end up: Even with the estimates in question, the magnitude of the move dictates that investors who want to put money to work should look for opportunities in the beaten-down areas of the market. It may be too early, as it's never safe to catch a falling knife, but you do want ideas in mind the second it looks like a bottom may actually hold, or we start to climb back on good news (or, possibly even more telling, they at least stop going down on bad news). At the same time, those who want to lighten up should consider any of their stocks that have ridden the HALO wave. We're not calling for a bottom in tech, nor a peak in the HALO trade. However, when you get moves and divergences like this, the tendency is to overshoot. This moment is built for stock picking, and it arguably requires us to be a bit more artful in our approach and less wedded to the science of relying on estimates. In a market prone to exaggerated moves, investors need to step back and focus on individual stocks. It's too simple to say that enterprise software will be fine, just as it is too simple to argue that all incumbent software vendors will be obsolete in five years (as the price action may have you believe). Instead, consider the businesses holistically, asking if it really makes sense that a generative AI model can replace or materially disrupt these businesses in such a meaningful way as to justify the stock destruction. If the answer is no, as we believe to be the case for our cybersecurity names â CrowdStrike and Palo Atlo Networksâ then you will likely find a time to buy. Salesforce, which reports Wednesday night, is admittedly a bit tougher at this point. Its applications are mission-critical for the salespeople and marketers who use them. But for the enterprise as a whole, they're not as critical as cybersecurity. Plus, they're more open to disruption of the seat-based licensing model and don't require the same network effect that helps cyber defend its clients. Proceeding with caution is also important because a market gripped by fear can stay irrational longer than you can stay solvent. At the same time, unless these HALO names can actually grow earnings, there is a limit to how high they can be bid â granted, the rotation away from software could push them beyond what a rational investor may deem appropriate. So, you want to book profits but not play the hero, making big calls in either direction. In the end, this market once again reminds us of the two things. The benefits of being a stock picker, which provides us the luxury of being able to go company by company and ask that crucial question â how much the business model can be disrupted? â even if we can't answer it in a quantifiable way beyond scenario analysis through financial modeling. The importance of diversification. Market darlings have become ugly ducklings so fast that it's arguably fantasy to think you could have been heavily weighted to software and tech and made the move to the cyclicals before taking a beating. Diversification may hurt during periods of concentrated winners, but it is the key to protecting against the destruction in software. If software was all you owned, think about how much that portfolio would be down in a few weeks and months. As we continue to navigate our way through this market on edge , we intend to focus heavily on individual fundamentals with diversification in mind. We'll look to trim winners that have made multiyear moves in a matter of weeks and search for bargain in the stocks of those companies that have seemingly been deemed to be on their death beds. (See here for a full list of the stocks in Jim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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'Old economy' stocks look expensive and software screams cheap. Is that enough to end the rotation?

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